Starting and running a business can be tough because of the financial strain, hours and various associated stresses. However, it can also be very rewarding. One of the biggest challenges entrepreneurs face is getting used to the unpredictable nature of business cash flow and generating enough business income to replace income that was previously received or that is necessary to maintain the lifestyle of the entrepreneur. Some entrepreneurs take the approach of taking as much money out of the business as possible, but that is typically not the best approach.
Without enough working money left in the business (working capital) there can be several challenges. They include:
- Additional stress and strain of worrying if you’ll have enough cash weekly (or daily) to pay vendors, employees, et cetera. This stress is no fun, especially if it ties in to being able to pay your employees.
- If business owners are not paying bills and managing payables themselves, there can be additional costs associated with someone spending more time managing and juggling the tighter-than-necessary cash flow. There can also be the additional cost of bank charges for insufficient funds. These additional expenses can allow the cycle to perpetuate itself.
- Challenges with raising funds. Lenders and equity investors don't like to see a business without owner equity in the business. If the owner continually drains the cash out of the business, he or she typically won't have any equity in the business and will have limited opportunities for traditional bank loans.
- The business is always teetering on the edge. One bad week or month and the business can put itself in dire financial shape.
By now, you should realize that I believe that a lack of working capital is not a good thing for the business or entrepreneur. To solve the problem, you first must determine how much cash to keep in the business. Part of that answer will depend on the specifics of the business and how capital intensive it is. However, a general rule of thumb is three to six months of operating cash. That figure can sometimes be a challenge, so one to two months of operating cash is still better than struggling from week to week.
The next step in solving the problem is to thoroughly analyze both your cash inflow and cash outflow. Part of that equation would also be for the entrepreneur to evaluate his or her personal spending and whether there are cuts than need to be made. I find this is often the toughest area to get entrepreneurs to make changes, but it is often necessary. On the business side, it's a matter of determining ways to increase cash inflow and minimize outflow. On the inflow side that doesn't necessarily mean sales – it can often be helped by timely invoicing, billing and collection.
On the outflow side, a business should continually be reviewing expenses and looking for opportunities to save, reduce or eliminate unnecessary expenditures, et cetera. In general, taking time every week to evaluate the financials of the business, and not just operate the business, can reap great rewards in this area.
My goal today was to help you understand why business owners need to keep working capital in the business and to offer some steps to get there.
Adam Shay, CPA (NC License Number 35961), MBA, is managing partner of Adam Shay CPA, PLLC. He focuses on minimizing taxes and improving the financial results of entrepreneurs, and is actively involved in supporting the Wilmington entrepreneurial and startup community. For more information, visit http://www.wilmingtontaxesandaccounting.com/ or email him at [email protected]. He can also be reached by phone at 910-256-3456.